Sunday, June 29, 2008

Psychologically and fundamentally speaking, it's not looking good in the equity markets. So I've decided to write a macroeconomic analysis in this blog post today.

My thoughts: A liquidity squeeze is back. Stocks are selling off as firms sell equities to raise cash. The Fed is attacking the liquidity squeeze by increasing the money supply. The increasing money supply is accelerating inflation and the devaluation of the U.S. dollar (and other developed world currencies). The only safe haven for cash appears to be in raw materials. Real estate, a traditional hegde against inflation, won't protect against currency devaluation in the current climate. My reasoning follows.

DJIA was down 9.4% in June. Last Thursday 90% of the NYSE trading volume was on downticks.

Usually, these conditions are where a stock market bottom might occur, but these are not ordinary times.

It seemed to me that some institutions might be selling equities to raise cash reserves last week. That's a bit frightening because it implies that there could be a cascade effect. The more banks or funds need to sell equities to raise cash, or the more there are margin calls that must be met, the more stocks will drop.

In August 2007 and January 2008 the Fed put a floor under the markets by:1) An emergency 75 basis point rate decrease - to increase liquidity for the financial syetem and fixed income markets. This was in response to the rapid deterioration and freezing of the CMO market in August. 2) Setting a floor price at which it would buy CMOs. This was in order to provide emergency liquidity to banks without enough marketable assets on their books (CMOs which could no longer be sold on the open market). This and the bail-out of Bear-Stearns (and facilitating its sale) saved the day this Spring.

But now things are bad again. What's the Fed (and all the other central banks) to do? Well, they have two options:

1) Let the credit crunch unfold. The crunch occurred because collateralized debt obligations (securitized) and other asset-backed securities can no longer be sold on the open market - there aren't enough (any) buyers. Fed non-action could lead to global bank failures and general catastrophe, so it's not really an option. However, there have been worrisome blaming noises coming out of the U.S. Congress - blaming the Fed for bailing out "rich" Wall Street bankers and overstepping their proper regulatory role. If Congress really understood how bad it was in January, and how the SEC was not even tuned in (per the WSJ), they wouldn't be so glib. Fortunately, the New York Fed has been quite vigilant.

2) The only other short-term option I can think of is to pump liquidity into the banking system. This will devalue the U.S. dollar.

Of course, every developed country is in a similar pickle to us. Most countries experienced massive credit borrowing, with scant collateral requirements, unjustified triple-A rated securities as collateral. Now that collateral is either impossible to value (for example, because there is no market for auction rate securities, certain real estate, CDOs, CMOs, and CDSs), or is devalued to the point where margin calls have been placed.

It appears that the Fed (and other central banks) have chosen option number 2. And that's one reason why we're seeing the developed world "devalued." It's true that the dollar's devaluation is primarily due to the massive trade deficit. Massive capital outflows, a rate of $500 billion annually, is occurring to petroleum producing countries. Our trade deficit is enormous (over $600 billion annually), and this puts downward pressure on the U.S. dollar (especially as Middle Eastern countries must de-peg their currencies from the U.S. dollar to slow their domestic inflation).

However, I think we're finally going to see money supply growth contributing significantly to inflation. Liquidity must be injected into the banking system in order to prop up banks and keep lending and the economy running smoothly.

Gold is a traditional hedge against inflation. But there will probably be a ceiling on the Gold price due to Central Bank selling of gold (especially over $1000/oz.). So we're seeing other commodities such as oil, food, metals, and commodified raw materials appreciate rapidly in price. They are the new hedge against inflation.

Real estate isn't going to hedge investors adequately against inflation, not when Europe, the U.S., and Japan are being devalued versus their developing-world peers.

The Fed and other central banks are doing what they must - providing liquidity to our system - so we don't have a banking collapse. This is accelerating the devaluation of our currencies. The only protection appears to be in commodities, and the companies that produce and sell commodities.

That's the way it seems to me currently. I wish I owned more raw materials!

Wednesday, June 11, 2008

Another brilliant new study from the SPAN lab at Stanford elegantly describes the neural predictors of the endowment effect. If you recall from some of our past blog posts, the Endowment effect describes the tendency for people to overvalue what they own, and value less what they don't.

A classic example of the Endowment Effect is playing out in the housing market. In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value (per Hersh Shefrin on NPR, March 30, 2008).

So what could drive people to cling to what they own and demand a higher price for it? It turns out that we are hardwired for "scarcity," and we don't want to let go of something we already have.

Brian Knutson, Elliott Wimmer, Scott Rick, Nick G. Hollon, Drazen Prelec, and George Loewenstein demonstrated in a study published by Neuron tomorrow, called Neural Antecedents of the Endowment Effect, that activation in the anterior insula (appearing in the top image), predicts the strength of the Endowment Effect.

Importantly, there are "individual differences" in the intensity of the Endowment Effect. That is, the activation in any one person's right anterior insula predicted how much value they assigned (and how much money they would demand from a bidder) for a consumer product. Each individual is different in this regard. And I imagine (though I have not seen it shown experimentally) our own propensity to the endowment effect changes over time depending on recent events in our lives.

Remember, the anterior insula often activates when someone is afraid of losing something, when they are in physical (and imagined) pain, and when they are experiencing disgust. So the idea of giving up a product is actually painful, and so we assign a higher value to it - to avoid the pain of loss.

Maybe that's another reason why it's so hard to let go of a sagging stock, especially one with a great story that is a former high-flyer. It's actually painful! More on this study and its implications later...

Monday, June 09, 2008

There are many events, and more importantly RUMORS of events, putting the market on edge.

There has been a surge in the MarketPsych Fear Index, in part due to Lehman's potential implosion, this time due to excessive and illiquid leveraged positions. With Lehman's request for $6 billion to fill in the hole dug by CMOs and excess borrowing, the market is back on the brink.

All this in the context of early summer. Recall from a prior blog post that there is truth in the saying "Sell in May and Go Away" - here is a great graph of the effect.

The specter of world oil and commodity price shock, inflation, flooding in U.S. agricultural regions and drought in Australia's, war with Iran, and general purpose catastrophe has reared it's head again. I don't mean to be glib. There is danger afoot. This isn't one of those merry "buy on the pullbacks" type of markets. Or is it?

There is indeed a developed world deleveraging happening. Will that spread to the developing world? It appears to be anticipated in recent stock market performance, but then, that may have been developed world money fleeing those markets, which is my opinion. And that doesn't mean the sky is falling.

The "sucker's rally" Frank and I predicted in March has come and gone. The DJIA passed 13,000 and then dropped back again. So here we are again, down 8% for the year.

So it's not looking good for anything except commodities and oil? No, that's not what I'm saying. I'm fairly interested in technology, pipe (yes, steel tubes for drilling), recycling, shipping, land, and many mining stocks. India and China aren't slowing their growth much, even though the US is, and they use lots of raw materials still. One land and oil trust that I've held for years, and plan to hold for many more is Texas Pacific Land (TPL), and also a pipe company, WEBC. Yes I own shares in these, and if you try to buy WEBC, you'll move the market, so please don't.

But wait, I need a legal DISCLAIMER here of some sort. Hmmmm..... (nervously scratching my head)... OK, so don't buy TPL or WEBC. I'm not recommending them. I'm just saying they're out there. I don't want to get sued because someone bought one now and sold it when it fell or went bankrupt and they lost money. Like I said, "DON'T BUY TPL OR WEBC!!!!!" Please don't, really.

I think I'm covered now. Whew!

And here's what's interesting: when investors are primed to be cautious because of one bad event, they often extrapolate that danger into other spheres (in my case, fear of litigation). When in fact they might want to find inflation-hedged stocks, which will continue to perform over time. But this is very difficult to do when you're afraid, because of neural "priming" in the anterior insula of the brain.

A fascinating study which we profiled here, by neurofinance geniuses Brian Knutson and Camelia Kuhnen, demonstrated that activation in the brain's anterior insula predicted excessive risk avoidance in an investing task.

Building on this finding, Greg Larkin, Brian Knutson, and collaborators found that anterior insula activation appears beneficial for learning which dangers to avoid. See their paper here. A light summary in Psychology Today is here. Interestingly, people who are more constitutionally "neurotic" (nervous) have more insula activation when faced with monetary losses. While being "neurotic" isn't usually seen as a personal positive (especially by neurotic people, who are already predisposed to worry that something isn't right anyway), it turns out that neurotic people (with their greater reactivity of the insula), are better at learning to avoid financial losses going forward. Insula activation did not affect learning to pursue or avoid financial gains. So I didn't do the study justice here, but hopefully more on its implications later.

While perma-bulls buy on the dips, more anxious investors may be rightly on the sidelines, waiting for these storms to pass. And their sitting out the volatility has now been proven right a few times over the past 12 months. Yet, then they might get stuck sitting and never acting. The market is always a balancing act.

In our in-house research, it's not the absolute level of market fear that predicts a market rally, but a retreat from a high level to a lower one. That's what you'll want to look for before buying. And for the past 12 months we've had historically high levels of fear.

What causes such retreats from peaks to lower levels? It's usually a resolution of some dangerous anticipated event. For example, the collapse of Bear Stearns and the Fed's willingness to step up and put a floor under the CMO market. That resolved a tremendous amount of uncertainty.

If Lehman can raise $6 billion, at a not horrible price, then I think another level of uncertainty will be resolved.

If the Iranian government stops declaring they plan to wipe Israel off the map (fat chance!), then there's another level resolved.

So it looks like the fear will continue for a while..., but we'll still hae some ups and downs that present good buying oppotunities in select sectors.